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A Big Red Panic Button for Stock Exchanges

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The idea of having a kill switch for major national exchanges sounds smart.

There should be ways to shut down trading by firms that seem to be suffering from giant trading errors, such as the flood of erroneous orders sent out by market maker Knight Capital Group last June.

(Read More: The Knight Fiasco: How Did It Lose $440 Million?)

The problem with kill switches is that someone needs to throw them. My own sources say that while the Knight incident was underway, people at Knight hesitated when it came to pulling the plug on the automated trading. They more or less had a kill switch or panic button but refused to press it.

What's needed, really, is a kill switch that doesn't sit at the broker-dealer but at the exchanges themselves. That's what's currently under consideration.

The latest idea, according to Traders Magazine, is to have an automated process that would track the "peak net notional exposure" of market makers. When a firm's notional exposure approaches agreed-upon caps, the exchanges would send out alerts. When the cap was breached, the exchange would shut down trading by the firm.

According to Traders, the unofficial name for these things will be "big red buttons."

The broker-dealers, of course, worry that they'll be shut down arbitrarily during some event triggering heavy trading. No one wants to tell their customers: "Sorry, pal, can't trade right now. We hit the quota."

One possible solution is to have the caps work on a sliding scale balanced against total volume. During periods of unusually high volume across a number of firms, the caps would rise. During periods of normal or low trading, they'd fall back down. The idea would be to capture abnormal trading volumes suggesting a problem.

(Read More: Fix? Experts Warn of 'Glaring Discrepancies' in China Data)

There are more complex possibilities under consideration, according to a person familiar with the matter. Under one of the proposals, broker-dealers would describe in some quite precise terms the circumstances under which they would want to be shut down. This could include unusual volume or even certain algorithmic behavior. The problem, however, is that the more tailor-made and complex the kill switches become, the more likely they are to fail.

In any case, the kill switches are probably quite far from becoming realities. Compliance and risk managers from the market makers and exchanges are still discussing the possible approaches. Once they reach a consensus, the plan will have to be submitted to the Securities and Exchange Commission, and it's anyone's guess how long it will take the SEC to reach a final rule.

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